1. Field of the Invention
The present invention relates to a system and method for creating a marketplace providing for and facilitating the cost effective exchange of institutional research and trade order execution services between asset management firms and executing brokers.
2. Background of the Invention
Asset managers are paid an annual fee schedule based on assets in an investment portfolio, which involves determining which securities to hold in the investment portfolio and implementing related buy and sell trading decisions. An asset manager's fee for managing an investment portfolio may vary with the type of assets (such as equity or fixed income), the selected investment strategy, and the size of the investment portfolio, but an annual fee of 0.50% (fifty basis points or one-half of one percent) on equity assets is fairly common.
The trading of stocks and bonds by asset managers (money managers) in an investment portfolio is a complex process. The asset manager not only controls the selection of the stocks and bonds to buy and sell, but also controls where and, within regulatory requirements, how each trade order is executed.
There are currently two separate processes, and supporting marketplaces for associated goods and services, that support asset managers in executing their responsibilities in managing investment portfolios. The first process involves the asset manager's directing trade orders to an executing broker. An asset manager establishes a relationship with a plurality of executing brokers to execute trade orders at a specific number of cents per share (which varies by the type of trade). The second process involves the asset manager's accessing and reviewing institutional research, which is created by an executing broker or independent research provider. The asset managers often desire such research for guidance in making their investment decisions. A research report will usually have a specific cost, usually in the thousands of dollars (which varies according to a number of factors associated with each report).
In practice, the asset manager will often agree to pay the cost of research by adding a cost increment to each share traded until such additional cost accrued over the volume of shares traded equals the stated cost of the desired research. Such additional costs added to the per share execution costs for the cost of research are referred to as “soft dollars.” For example, a trade may incur a penny per share execution cost ($0.01 per share) and have three cents per share ($0.03 per share) added on as a “soft dollar” cost, for a total execution cost of four cents ($0.04) per share. A research report may cost $7,500 and thus require that 250,000 shares be traded through the executing broker at four cents per share ($0.04) in order to pay the dollar cost of the desired research report (i.e., 250,000 shares×$0.03 per share $7,500). Very importantly, the “soft dollar” costs are not paid for by the asset manager, but are passed through to the shareholders or beneficiaries in the mutual funds or investment portfolios managed by that asset manager.
Referring to FIG. 1, an asset manager 102 (such as mutual fund companies or institutional asset management firms) usually maintains relationships with a plurality of executing brokers 104 (including, for example, broker-dealers (e.g., Merrill Lynch™, Morgan Stanley™, or UBS Paine Webber™), market makers (e.g Knight Capital™ or Schwab Capital Markets™), exchanges (e.g., the New York Stock Exchange™ or NASDAQ™), electronic communication networks (ECNs) (e.g., INET™ or TRAC™), direct market access (DMA) vendors (e.g., Lava Trading™, Sonic™, or UNX™) and dark pools or crossing networks (e.g., LiquidNet™ or Pipeline™)). These executing brokers 104 are often selected based on the additional goods and services (such as research) they can provide to an asset manager 102.
The cost of these additional goods and services (such as research, data feeds, and software) is added over and above the trade's cost of execution and results in a higher total trade cost than what would otherwise be incurred by the fund or investment portfolio. The “soft dollar” costs for these additional services utilized by an asset manager 102 are passed through as revenues to various research providers 106 for their research, systems, software, data feeds, etc. and are paid for by the shareholders or beneficiaries through higher brokerage (trading) expenses and the resulting lower returns (lower performance) of their funds or accounts. These trades are usually executed at an average cost of 2.50 cents to 5.00 cents per share. In FIG. 1, the executing broker 104 and research provider 106 are shown as separate entities. In practice, however, the executing broker and research provider services are often through a single entity (such as Merrill Lynch™).
FIG. 1 provides an overview of the process whereby the asset manager 102 agrees to add “soft dollar” costs to the brokerage (trading) costs of an investment portfolio in order to pay for institutional research desired by an asset manager 102.
Asset manager 102, in step 1, contracts with research providers 106 in order to receive research.
The research provider 106, in step 2, delivers the research to the asset manager 102.
The research provider, in step 3, presents an invoice for “soft dollars” to an executing broker 104 for the research provided to the asset manager 102.
The executing broker 104, in step 4, presents the invoice for research to the asset manager 102 for their review and confirmation.
The asset manager 102, once the invoice is approved, (A) records the invoice, (B) derives the trade obligations to pay the “soft dollars,” and, through the trading desk and order management system, (C) directs the trade orders to the specified executing broker 104 for commission volume to offset the cost of the research. The asset manager 102 (D) transfers the trade details to the soft dollar administration system to track the plurality of research requests and the resulting “soft dollars” paid to research providers.
Once the asset manager 102 confirms the trade did occur and the “soft dollars” are properly accounted, the asset manager 102, in step 5, confirms receipt of the research and payment of “soft dollars” to the executing broker 104.
The executing broker 104, in step 6, pays the invoice for research as presented in step 3, to the research provider 106 on behalf of the asset manager 102.
The utilization of “soft dollars,” as illustrated in FIG. 1, is a long-standing industry practice. It is interesting to note, however, that these additional trading costs are not included, for example, in the operating expenses of a mutual fund (such as a quoted 1.10% annual operating expense) that are disclosed in a fund's prospectus (required disclosure document). As such, a fund's trades are often directed to executing brokers 104 so as to shift the cost of external research from the mutual fund company or institutional asset manager 102 to the investment portfolio and its shareholders or beneficiaries. Finally, asset management contracts usually contain a clause that eliminates any requirement that “soft dollar” costs incurred by a specific investment portfolio (and its shareholders or beneficiaries) benefit the investment portfolio responsible for paying the additional “soft dollar” costs. As such, an investment portfolio may pay additional costs for services that do not benefit the underlying shareholders or beneficiaries paying the additional “soft dollar” expense.
In fact, most shareholders in mutual funds are not aware that a fund's trading costs are in addition to the fund's annual operating expense (as disclosed in the prospectus) and, as such, serve to lower the investment performance (rate of return) of their funds. These same fund shareholders are also usually not aware that asset managers 102 are using the assets of the fund to pay additional “soft dollar” costs for trades in their mutual funds as a vaguely disclosed and unaccountable pool of cash to offset the asset manager's internal research and operating expenses in order to increase their corporate profits.
Overall, the current process of using “soft dollars” by asset managers to direct trades in order to generate “soft dollar” revenue is overly complex and expensive to shareholders and beneficiaries in terms of the lower performance in the investment portfolios. The current process for utilizing “soft dollars” was established in 1975 when Congress enacted Section 28(e) to permit an asset manager to use client commissions to pay for brokerage and research services. The Securities and Exchange Commission (SEC) provided additional guidance in 1986 as to what constitutes eligible research, products, and services under Section 28(e). In July 2006, the SEC released an Interpretative Release that more clearly defined what constitutes eligible research, products, and services in an attempt, according to many press reports, to curb perceived abuses of “soft dollars” in trading by asset managers.
Most recently, in May 2007, SEC Chairman Cox sent a letter to both houses of Congress urging Congress “to consider legislation that repeals or substantially revises Section 28(e) . . . which provides a ‘safe harbor for certain ‘soft dollar’ arrangements.’”